Breaking Down the Derivatives Market

Derivatives can be complex products, but the derivatives market doesn't have to be. Unfortunately, the recently passed Dodd-Frank Act has put an end to the days of a well functioning derivatives market and heaped upon it an unhealthy portion of complicated rules and requirements.

While a mountain of toxic derivatives deals helped bring down AIG, the product wasn't the problem. Unwise derivative bets were just a symptom of a moral hazard disease in the market environment. Incentivize firms appropriately to watch their levels of risk, and an unregulated derivatives market will do no more damage than a highly regulated one.

Nevertheless, Congress has gone after derivatives trading with a vindictive vengeance. In the hours before Congress voted to pass their faux-overhaul of Wall Street regulations, Sen. Blanche Lincoln stood up in defense of the derivatives provisions: "This legislation brings a $600 trillion unregulated derivatives market into the light of day, ending the days of Wall Street's backroom deals and putting this money back on Main Street where it belongs."

A derivative is a catchall definition for any contract that derives its value from an underlying asset or security. For example, AIG sold "credit default swap" (CDS) insurance contracts on pools of mortgages that paid out if housing prices dropped below a certain value. At the time of their demise, AIG had over $400 billion CDS contracts. The value of the credit default swap was derived from the value of the underlying mortgage-backed security pool. AIG began to come apart when the value of mortgage-backed securities was destabilized by the subprime housing crisis in late 2007, threatening them with hundred of billions in losses.

In the course of the housing bubble, few noticed the huge risks AIG was taking on by overloading its books with credit default swaps on subprime mortgage debt. Sen. Lincoln says that the new derivatives legislation will "rein in the reckless Wall Street behavior that nearly destroyed our economy" and provide "one hundred percent transparency and accountability to our shattered financial markets." Essentially, the goal is to protect investors and consumers from another AIG.

While this is an admirable goal, the way Dodd-Frank seeks to accomplish this by unnecessarily restricting businesses from managing their risks, increasing costs, and ignoring the real causes of the crisis.

The core of the derivatives trading reform is a new requirement that nearly all derivatives trades-the auto manufacturers and corporate end-users received an exemption-be done through a clearinghouse on an open exchange. Second, financial institutions must make most of their derivatives trades from separate, non-deposit funded subsidiaries to separate out the risk.

These and a number of other forthcoming rules from the Commodity Futures Trading Corporation are intended to help regulators and investors better monitor the build up of potentially risky derivative contracts in a company or the market as a whole. And those wishing to make derivative contracts will have to meet higher capital requirements and regulatory scrutiny. Financial institutions can still create customized derivatives away from the exchanges, but they will entail significantly higher margin standards and costs to discourage excessive risk taking and operations away from the standard products.

In theory this all sounds reasonable, but it doesn't actually address the causes of risk in the system. One of the core lessons from the financial crisis that Sen. Lincoln's bold words overlook is that regulators are not capable of fully regulating the market. More transparency and clearinghouses, objectively speaking, are good. To be sure, they will allow a much better understanding of risk in the system. But more transparency in the market doesn't guarantee regulators will act or even know how to act. The Fed knew a lot about the subprime market during the housing bubble but chose not to address the potential risks of so much poor quality debt.

One thing that Sen. Lincoln and Dodd-Frank miss is that all derivatives are not created the same and demanding more collateral from commercial companies that use derivatives to insure against potential shifts in the market is simply raising costs and limiting the use of productive capital, not necessarily protecting the market. The Wall Street Journal offered a good example of this:

"[FMC Corp.] sells a lot of agricultural chemicals around the world, often in barter deals to cash-strapped farmers. In Brazil, say, farmers might trade FMC a portion of their expected soybean crop in return for a load of pesticides. FMC does not want to hold the risk of falling soybean prices, so it buys a derivatives contract tied to the date when the farmer is to deliver the soybeans. Under a typical deal, a bank agrees to pay FMC the difference if the price falls between now and when FMC takes delivery. Meanwhile, FMC agrees to pay the bank the difference if soybean prices rise."

As the Journal notes, this does not create systemic risk. And the same logic extends to international shipping companies with fuel price exposure or lumber exporters locking in exchange rates.

Furthermore, they are not a cure-all, even for more risky derivatives, which, if built up in one company like AIG, could pose a systemic risk. Indeed, clearinghouses are susceptible to collapse too if the market suffers a severe downturn. As such, they would be the next ideation of too big to fail. As John Carney writes at BusinessInsider.com, creditors and managers would be less like to closely monitor the risk of clearinghouses, and would avail themselves of cheap funding from an implicit government guarantee.

A better system would have required transparency through reporting of derivatives trades, but not necessarily clearing (though that could have been offered as a way to report trading if chosen). This approach would have focused on making companies more responsible for their own risks, rather than present a labyrinth of red tape that will provide misplaced confidence and incentivize manipulation of the limitations.

Like showing your ID each time you enter a bar, companies could be required to report each of their trades to a central source in order to continue business operations. This private company or regulatory agency would then aggregate the information for the market as a whole-like a clearinghouse. There could even be a way companies could privately report certain trades that they felt might compromise proprietary information if open to the public.

In this system, the regulators and the market could then be watching to see if any company is building up too much risk, but without excessive margin requirements and restrictive standardization. If a company starts to take on too much risk-like the out of town business man at the bar who's had a few too many-the market will price that in and adjust. Just as police can't catch every bar drunk, regulators can't catch every market imbalance. But citizens in a bar know when the drunk has reached his limit.

Even beyond all this, higher margin demands on derivatives could require American companies to pay out up to $1 trillion more in collateral, depending on how regulators set rules over the next 18 months. This is capital that otherwise could be invested itself in the economy. In exchange, the legislation offers a complicated framework that will limit financial innovation and curb market activity. Not exactly a path to sustainable recovery.

The ultimate problem is that the new comprehensive derivatives regulation is based in a misunderstanding of the causes of the crisis. Sen. Lincoln believes that "after spending countless hours on this legislation and digging into the details of the derivatives world" the Wall Street overhaul legislation "is strong, thoughtful, and groundbreaking reform that will fundamentally change our financial system for the better." But the whole point was that over confidence in narrowly focused regulation created moral hazards in the previous system—moral hazards that haven't been eliminated by Dodd-Frank.

It is likely that the whimsical confidence of policymakers in designing this purportedly safe system will wind up shattered along with markets and economies in the future, as it has in the past. While the new rules will likely provide some protection for the market-at the expense of economic growth spurred on by investment and financial innovation-they are not a cure all and should not be trusted as great protector of the marketplace.